Recent Guidance Extends Deficiency Interest-Free Periods

In late 1999, the IRS issued Rev. Rul. 99-40 and Chief Counsel Notice (35)000-165 (republished as Chief Counsel Notice (35)000-168), which adopted together the principle for deficiency-interest purposes that any return overpayment carried over (i.e., credit elected) to the following year nevertheless would be considered as remaining "paid" for the first year until the return overpayment actually was needed to pay an installment of estimated tax for the following year. Since deficiency interest accrues only when the tax liability is both due and unpaid, this principle establishes a "no deficiency interest" (NDI) period running from the due date of the first year (Yr1) until the time (and in the amounts) that the return overpayment is applied to the estimated tax installment obligations of the subsequent year (Yr2).

In the past year, the duration of the NDI period has been addressed in a series of case-specific Field Service Advices (FSAs). These FSAs extended the NDI period to the due date of the Yr2 return and, in one case, slightly beyond it. However, the rationale for ending the NDI period at that time seems unclear; an argument could be made to continue the NDI period as long as continuing credit-elects can be traced back to the deficiency year.

May Department Stores, Inc., 36 FedCl 680 (1996), acq., and Sequa Corp., DC NY, 6/8/98, which followed the principles of Avon Products, 588 F2d 342 (2d Cir. 1978), had established a gradually longer NDI period, first, in May, to the time the Yr1 credit-elect was applied to the Yr2 installment to avoid the estimated tax penalty, and then to the due date of the Yr2 return, in Sequa, when not needed for any Yr2 estimated tax purpose. May set the NDI period as the estimated tax installment due dates, and Sequa established that the NDI period could extend past the last installment date. However, Sequa did not establish the theoretical ending date, and the Service has not published formal guidance accepting that decision.

Recent Guidance

In FSA 200049001, the Office of Chief Counsel dealt squarely with the situation when the Yr1 overpayment was not needed to pay any installment of Yr2's estimated taxes. This FSA cited May and Sequa as holding that the credit-elect may not be considered a payment of estimated tax installments when those taxes are fully paid otherwise, without consideration of the credit-elect. However, recognizing that Rev. Rul. 99-40 did not address the situation beyond the last estimated tax installment, the FSA expressed the IRS's view that the unextended due date of the Yr2 return was the ultimate ending date of the NDI period.

Thus, the FSA represented both good and bad news, as it extended the NDI period to the Yr2 return date, but no further. This latter position was based on language in Sec. 6513(d), stating "such amount [of estimated taxes paid] shall be considered as a payment of the income tax for the succeeding taxable year," and a statement in Sec. 6513(b)(2) that for purposes of limits on credits and refunds, the amount of pre-return payments "shall be deemed to have been paid on the last day prescribed for filing the return...for such taxable year...." Thus, the FSA concluded, "the Government should also be treated as having lost the use of that money as a payment of the original year's tax at that point"; see also FSAs 200014012, 200012049 and 200042003.

Use of Funds

The Service's view that the NDI period ends at the Yr2 return due date may seem to have appeal because, for some purposes, the overpayment becomes a "payment" of Yr2 taxes at that time. However, its rationale essentially is equivalent to the government's unsuccessful argument in May and Sequa, as well as the rationale later abandoned in Rev. Rul. 99-40. In Sequa (which the IRS cited favorably in all FSAs released on this issue in 2000), the court found that Sec. 6513(d) provides no reason to depart from the "use of money" principles used by the courts to create the NDI period.

Further, the better view appears to be that Sec. 6513(d) should not be interpreted as holding that Yr1 taxes become "unpaid" when the Yr1 overpayment is not needed to satisfy the Yr2 liability. Sec. 6513 is a statute-of-limitations provision designed to permit a waiver of sovereign immunity for refund claims; it does not purport to address deficiency interest or use-of-money principles. In May and Sequa, the government argued that once the credit election was made, the overpayment so elected was effective to move the funds from Yr1 to Yr2 because it was "applied" at that time. As a result, the government lost the use of the money (for the Yr1 liability) at the time of the election (or as directed by the election). The courts in May and Sequa, and the IRS in Rev. Rul. 99-40, rejected the "effective election" approach and held that (as relevant to deficiency interest) the application of funds occurs only when the funds are needed in a later year, regardless of the time specified in the election.

The rationale used by the courts in May and Sequa and the Service in Rev. Rul. 99-40 would seem no less apt after the unextended date of the Yr2 return than before that date. As long as the overpayment (1) can be traced back to the deficiency year, (2) was outstanding for that period of time and (3) has not been applied or refunded for another purpose, the "due and unpaid" principle in Avon Products should continue to apply, so that deficiency interest is avoided.

Extended NDI Period

In FSA 200018025, the IRS seemed to acknowledge a problem with its position that the Yr2 return date inevitably was the ending point of the NDI period. In that FSA, it acknowledged the court cases and revenue ruling as supporting the proposition that the credit could not be deemed to apply to the next year's estimated tax when other funds were available already to pay the full amount of the estimated tax (and thus the funds were not "unpaid" from Yr1). However, subsequently, the Service looked to the "refund" provision rather than the "deemed paid" provision of Sec. 6513(d), to establish when those funds became "unpaid."

When a credit-elect from Yr1 was refunded to the taxpayer shortly after the due date of the Yr2 return, under the FSA, the IRS held that the government lost use of the money on the date it was refunded (Sec. 6611(e)), rather than on the "deemed paid" date. The FSA concluded that the Yr1 overpayment "remained available to offset the underpayment up to the refund date of estimated taxes," even when that refund was made after the time the amount would be deemed paid to Yr2 under Sec. 6513(d). It seems difficult to rationalize why the NDI period should continue past the Sec. 6513(d) "payment for year 2" date in the case of refunds, but not when the overpayment was further credit-elected. In both cases, the key consideration should be whether the government or the taxpayer has use of the funds; when the funds remain in the Treasury, regardless of the account in which they are considered residing (and not having paid a tax then due), the government has use of the funds.

Taxpayers may disagree with the Service's view on the ending date of the NDI period, arguing that credit-elect amounts not applied to estimated taxes nor used to pay the taxes on the Yr2 return should continue to be available to counter deficiency interest of Yr1 until refunded or used to pay a tax then due. These taxpayers may find support in the spirit of the "interest netting" principles in Secs. 6621(d) and 6601(f). While the credit-elect situation does not fall literally within those provisions, because no overpayment interest is allowable on the credit-elect, the extended NDI period as proposed is consistent with a "comprehensive interest netting" concept.

From Daniel J. Wiles, J.D., Washington, DC